Luck vs. Skill

March 3, 2016 - 0 comments

On March 2nd, 1962, Wilt Chamberlain scored 100 points for the Philadelphia Warriors in a 169 – 147 win over the New York Knicks. This set the NBA single-game scoring record which still stands today. The game was not televised, in fact, no video footage of the game has ever been located. The stadium was only half full, and no members of the New York press were present. Audio recordings do exist, but only of the fourth quarter. Despite the lack of evidence, it’s not hard to believe that Chamberlain, who averaged 50.4 points per game that season, could score 100 points. His skill was obvious, and any coach would be confident putting the ball in his hands. Placing confidence in the skill of a money manager is much more challenging; the stock market is a world of randomness.

Imagine that a financial advisor who engages in security selection states an average annual return of 30% over a ten year period – a return in line with the 3 top performing hedge funds in the world. Unlike mutual funds, individual financial advisors do not have public performance disclosure requirements or standards, so much like Chamberlain’s 100 point game, supporting data for these numbers might be hard to find. However, assuming that the returns are accurate, they raise an interesting question: should a financial advisor who has produced returns of 30% per year for the past 10 years earn the confidence of investors?

Wilt Chamberlain was a physical specimen, and it was obvious that he wasn’t just getting lucky when he attacked the basket. It’s not nearly as obvious, though, when a financial advisor’s performance is due to skill rather than luck; while Chamberlain was clearly competing against smaller, less athletic players, stock pickers are competing against large institutions and hedge funds. Is it reasonable to believe that a financial advisor has more knowledge and expertise than their institutional competition? Is it likely that those 30% returns will persist?

As an investor, there is a choice to be made between following science-based academic evidence, which points to low-cost globally diversified market based investing, or following investment strategies that, while empirically successful over relatively short periods of time, have not been peer reviewed or statistically proven to persist through time. If capital is being used to achieve specific goals, like retirement, then following the evidence is the only responsible way to invest.